Forget Stock Picking: Pros Still Like Some Index Funds

Receive the latest business updates in your inbox

Although sector picking is difficult in this kind of market, indexes still provide a return for investors without the hazard of getting burned by individual stocks.

Updated at 6:34 PM PDT on Monday, Feb 9, 2009

Not everyone believes this is a stock-picker's market.

Despite the sharp selloff in major stock indexes, some investment pros are keeping their clients in index-based exchange-traded funds that track certain sectors.

Although sector picking is difficult in this kind of market, indexes still provide a return for investors without the hazard of getting burned by individual stocks.

"Index funds are what most people should be using," says John Jacquemin, who runs an institutional hedge fund as principal at Mooring Intrepid Opportunity. "I don't think anybody is good enough to call market tops and market bottoms generally. The average person doesn't have the time or interest or knowledge to be able to do that."

ETFs provide a convenient and accessible vehicle for investors to play indexes, and firms are developing new ones all the time.

Some of the more popular are the iShares, SPDR , ProShares and Rydex families. Among the newer offerings, the PowerShares Preferred (AMEX: PGX) ETF, which tracks the Merrill Lynch preferred securities index, has been performing well as of late and has returned 5.15 percent in the past three months.

Vanguard also has a number of popular funds, including its Total Stock Market (NASDAQ: VTI) fund which plays across all sectors and all indexes.

But many investors instead are flocking to more specialized funds, particularly the dividend-paying offerings that provide yield even in tough market times. They include the First Trust Value Line Dividend Index , which is paying a yield approaching 4 percent.

"I've read a lot about the whole stock-picker's argument in bear markets," says Don Humphreys, president of Voyager Wealth Management in Harrington Park, N.J. "It actually does not necessarily prove out in the numbers. If anything in bear markets you're better of being in index funds."

While Humphreys uses some ETFs for his clients, he employs a passive investment strategy using some Vanguard and Dimension funds to provide diversification and safety.

"Over the long run they definitely provide more value than active funds," he says. "Regardless of a bear market or bull market I'm still a big believer in them."

Be Specific

To be sure, index investing is fraught with peril, particularly in an environment where many companies, particularly banks, are announcing dividend cuts, moves that cut into the value of the ETFs that track the underlying equities.

In fact, even many of the best-performing ETFs are still showing negative returns over the past year, but often not as bad as the major indexes.

For Investors

Plan Ahead: Buy Small-Cap Consumer Stocks

Gold Seen Jumping to $1,200 as Bailouts Mount

Time to Sell or Go Bargain-Hunting?

Few are advocating broad index plays--the Dow 30 and the S&P 500 particularly, due to their heavy bias towards banks--and encourage investors instead to seek indexes in specific sectors.

"I don't believe (broad) indexing works primarily because it only works in up markets and doesn't work in down markets," says Vern Hayden, president of Hayden Wealth Management. "I think I have a better chance of making money picking sectors."

Hayden is selective in his use of ETFs--the SPDR Gold Shares (NASDAQ: GLD) fund gives him precious metal exposure, and he also likes the First Eagle Global Fund (OTC Funds: SGENX), which holds a variety of domestic and international stocks as well as some short-term debt.

For Hayden, the ETFs he uses allow him to strike a balance between the need to be nimble and a strong desire to reduce risk.

"Initially I kind of was against the ETFs," he says. "If I am going to move around and not buy and hold, then the ETF is probably the most efficient way to go about things."

Moreover, the sector-specific ETF can give investors shelter from the fallout in financials that they wouldn't get investing in the broad indexes.

"People may use them as trading vehicles such that they might jump into them without looking under the hood," says Chip Hanlon, president of Delta Global Advisors in Huntington Beach, Calif. "But at the same time it's easy enough to look at them. They're very transparent."